Financial Assets

What are financial assets
Financial assets include Cash, and those assets that can be converted to cash in a reasonably short period of time - one year at most, but less time in many cases. We will study the following financial assets:

• Cash
• Cash Equivalents
• Short Term Investments
• Accounts Receivable

Valuation of financial assets
Financial assets are valued as of balance sheet date, when financial statements are prepared. They are valued at the equivalent of their current Cash value - what they would be worth if we could convert them to cash now. In the case of Cash, it is already at it's current value. Short Term Investments are reported at their current market value. Accounts Receivable are adjusted for possible bad debts.

Cash and Cash Equivalents
Cash is just as the word suggests. It includes cash money including paper and coins, checks and money orders to be deposited, money deposited in bank accounts that can be accessed quickly. The term liquid refers to Cash, and the ease or difficulty of converting an asset into Cash.

Cash Equivalents are highly liquid short term investments that can be turned into Cash very quickly. These include US Treasury bills, money market accounts and high grade commercial paper. When corporations need to borrow money for a very short time, they often sell commercial paper. These come due within a few months at most, and pay a higher interest rate than other investments.

Short Term Investments
Short Term Investments include stocks and bonds that the company intends to hold only for a short time, and then sell and convert back to Cash. We consider it a good practice to convert unneeded cash to an investment account, where it can earn interest, dividends or show capital gains. These are shown on the balance sheet at their current market value, even if that is higher than the price paid for the investments. This is one of the few times we increase a balance sheet item above it's historic cost.

Accounts Receivable
Companies often sell to their customers on credit. The amount the customers owe is called Accounts Receivable (AR). We would record AR at the same time the sale is made, deducting any cash paid at the time of purchase, etc. When customers pay, we subtract the payment from their accounts receivable balance.

Most companies use an Accounts Receivable Subsidiary Ledger, which is similar to the General Ledger. The subsidiary ledger contains detailed information about each customer's account - purchases, payments, returns, adjustments, etc. Most companies send statements at the of each month, listing the monthly transactions and ending balance due from each customer.

Uncollectible Accounts
When businesses sell on credit, they run the risk that some customers will not pay their bill. Legitimate complaints, errors in billing , etc. are dealt with in an appropriate manner, and the books are adjusted as needed to correct any errors, or show returns and allowances (price adjustments). Still, some customers don't pay their bill, for any of a variety of reasons, and we must have a way to deal with this in the books, and on the financial statements.

We do this by setting up an account that is a companion to Accounts Receivable. It is called the Allowance for Uncollectible Accounts (or something similar - Allowance for Doubtful Accounts is often used click here for funny true accounting story).

Allowance for Doubtful Accounts is called a contra-asset account. It is a companion to Accounts Receivable, and has an opposite balance. When we net the two balances, we get the amount we expect to collect from customers, allowing for those who don't pay.

The allowance account is established each year, at balance sheet date. We usually prepare an Accounts Receivable aging report, which gives us a history of customers accounts tabulated in columns, each column representing one month. We can quickly see which customers are late paying their bills by 30 day, 60 days, 90 days, etc. We would expect that if a customer hadn't paid their bill after 90 days there is a good chance they won't pay at all. The risk of loss goes up as accounts go unpaid for longer periods of time.

Companies use the aging report to make a dollar estimate of how much they will lose in unpaid account balances. At that time we have no way to know exactly which customers won't pay. But by tracking its business history a company can estimate a dollar amount that they believe is reasonable.

When the allowance account is established, an expense account is also debited. That account is called Uncollectible Accounts Expense, Bad Debt Expense, Provision for Bad Debt, or something similar. So the loss due to bad debts is recognized as a normal business expense on the Income Statement.

Writing Off Bad Debts
Periodically, and no less than once a year, a company must review it's accounts receivable and identify any customers who have not paid their bill for a very long time, generally over 90 days. Information is gathered about these customers, and attempts at collection should be made. However, the customer may be out of business, bankrupt, etc. and it is unlikely the company will be paid by these customers.

When this happens, the debt is no good and should be removed from the books. We do that by making an entry to both Accounts Receivable and the allowance account, reducing the balance in both accounts. Writing off bad debt should be done with management's approval. Potentially collectible accounts should be pursued; only legitimately uncollectible accounts should be written off.

The allowance method is acceptable for accounting, and correct under GAAP. However, no allowance expense is permitted for tax returns. Only accounts actually written off can be expensed on a tax return, and then only in the year the account is deemed uncollectible.

Financial Analysis
Financial statements contain valuable information, but it must be analyzed to make relevant and correct decisions. Certain ratios are commonly used by investors and analysts. These are not difficult. All the information you need is already in the financial statements, as required by GAAP. And these ratios are used by thousands of people on a daily basis. No college degree or great math skills are required to use financial ratios.

Ratios can be used to evaluate a company's performance over a number of years. It can also be used to compare several different companies. Bankers often use ratios when considering a loan application. And investors calculate ratios to decide which stocks to buy or sell.

Read more...

Bank Reconciliation

Banks send statements to their depositors each month. A bank reconciliation compares the information in the bank statement with the company's Cash account, and finds any discrepancies. These are recorded or dealt with as needed. The process is fairly simple.

The bank balance and book Cash balance are listed on a piece of paper (now we often use computers). Some items show up on the bank statement, but have not been reflected in the books yet. These items will be added to or subtracted from the book balance.

Some transactions have been recorded in the books, but have not yet cleared the bank. These include deposits in transit, which are not yet posted in the bank's records - those made after the date of the bank statement. And outstanding checks - those which have been written and mailed, but haven't cleared the bank yet. These items are added to or subtracted from the bank balance.

Once all items have been included, the adjusted bank and book balances should be equal. If they are not, the reconciliation needs to be reviewed and corrected until the two amounts are equal.

Bank Reconciliation

Adjustments to Bank Balance	Adjustments to Book Balance
Add Deposits in transit	Add anything on bank statement that increases cash balance, but has not been recorded in the books: bank collections, interest earned
Subtract Outstanding checks	Subtract anything on bank statement that decreases cash balance, but has not been recorded in the books: bank charges and fees, bad checks, interest charges
Bank errors (add or subtract as needed); notify bank of error; these don't happen very often, but we need to watch for them	Add or subtract for accounting errors relating to deposits or checks.
Do not record any of these adjustments in the books.	These adjustments must be entered as journal entries, so the books agree with the bank balance.

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Merchandising Activities (2)

Inventory Shrinkage
If you throw a good wool sweater in a washing machine full of hot water, what will happen? You ladies already know the answer to that question. If you're a guy you may need to ask you wife, girlfriend, sister, or mother. Go ahead.... we'll wait.......

OK, now that you know the sweater will shrink, or get smaller. Guys, if you do this to your wife's favorite cashmere sweater we'll be forwarding your mail to the doghouse for the next month or so.

Well, inventory also shrinks. But not because we washed it in hot water. In fact inventory shrinkage occurs for a number of reasons, and it is just as it sound - inventory gets smaller. But how should this happen? Things happen to merchandise while the store has it available for sale. Here are some of the things:

Theft - by employees or customers
Spoilage - milk, meat, vegetables, past the expiration date
Obsolescence - computers, software, clothing (last year's styles)
Display - merchandise put on display often can't be sold later or must be discounted
Grazing - customers or employees eating food available for sale
Damage - broken bottles, bent cans, frozen foods left out of the freezer

The sum total of all these items contributes to the difference between the Inventory account and the physical count. There might also have been errors made in the Inventory account during the year, adding to the difference.

Special Sales and Purchase Accounts

Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a different account. This is done to help track the number and dollar amount of these types of transactions.

Sales accounts deal with customers and sale transactions

• Sales Returns and Refunds
• Sales Allowances
• Sales Discounts

Purchase accounts deal with suppliers and purchase transactions

• Purchase Returns and Refunds
• Purchase Allowances
• Purchase Discounts

Notice the close similarity between the account titles. They are almost identical, but apply on opposite sides of the purchase and sales cycles. Sales accounts are used in conjunction with selling merchandise and dealing with customers. Purchase accounts are used in conjunction with buying merchandise and dealing with suppliers.

By tracking these types of transactions in their own account managers have the opportunity to better understand their business. Are too many refunds being given? Why? Are we buying defective merchandise from a certain supplier? Are Sales Allowances cutting into our gross profit too much? Are we taking advantage of our Purchase Discounts when available?

The key to business profits is to identify each and every item that can be improved, and then improve it. Managers can raise prices. But they can also cut costs, reduce waste, increase efficiency, take discounts when available, and many other things to improve the profitability of their business.

Freight In vs Delivery Expense
Freight In is the cost to have merchandise shipped to your store. Freight In is a cost of purchasing merchandise, and becomes part of Cost of Goods Sold in the Income Statement. Sometimes a company has to pay a separate charge for Freight In. At other times the cost may be included in the cost of merchandise from the supplier. In any case, the cost of Freight In is added to the cost of the merchandise.

example:
XYZ, Co. buys 100 units of Product R for $7500. The trucking company charges $500 for the shipment. The total cost of the merchandise is $8000. Each unit costs $8000 / 100 = $80. They should set their selling price based on a cost of $80.

Delivery Expense is the cost to ship or deliver merchandise to your customer after a sale. Delivery Expense is a Selling Expense, and is included under that caption in the Income Statement.

Read more...

Merchandising Activities (2)

Inventory Shrinkage
If you throw a good wool sweater in a washing machine full of hot water, what will happen? You ladies already know the answer to that question. If you're a guy you may need to ask you wife, girlfriend, sister, or mother. Go ahead.... we'll wait.......

OK, now that you know the sweater will shrink, or get smaller. Guys, if you do this to your wife's favorite cashmere sweater we'll be forwarding your mail to the doghouse for the next month or so.

Well, inventory also shrinks. But not because we washed it in hot water. In fact inventory shrinkage occurs for a number of reasons, and it is just as it sound - inventory gets smaller. But how should this happen? Things happen to merchandise while the store has it available for sale. Here are some of the things:

Theft - by employees or customers
Spoilage - milk, meat, vegetables, past the expiration date
Obsolescence - computers, software, clothing (last year's styles)
Display - merchandise put on display often can't be sold later or must be discounted
Grazing - customers or employees eating food available for sale
Damage - broken bottles, bent cans, frozen foods left out of the freezer

The sum total of all these items contributes to the difference between the Inventory account and the physical count. There might also have been errors made in the Inventory account during the year, adding to the difference.

Special Sales and Purchase Accounts

Merchandisers use a few special accounts. When a sale is made, sometimes the customer returns merchandise for a refund. We do not reduce the sales revenue account. We enter the refund in a different account. This is done to help track the number and dollar amount of these types of transactions.

Sales accounts deal with customers and sale transactions

• Sales Returns and Refunds
• Sales Allowances
• Sales Discounts

Purchase accounts deal with suppliers and purchase transactions

• Purchase Returns and Refunds
• Purchase Allowances
• Purchase Discounts

Notice the close similarity between the account titles. They are almost identical, but apply on opposite sides of the purchase and sales cycles. Sales accounts are used in conjunction with selling merchandise and dealing with customers. Purchase accounts are used in conjunction with buying merchandise and dealing with suppliers.

By tracking these types of transactions in their own account managers have the opportunity to better understand their business. Are too many refunds being given? Why? Are we buying defective merchandise from a certain supplier? Are Sales Allowances cutting into our gross profit too much? Are we taking advantage of our Purchase Discounts when available?

The key to business profits is to identify each and every item that can be improved, and then improve it. Managers can raise prices. But they can also cut costs, reduce waste, increase efficiency, take discounts when available, and many other things to improve the profitability of their business.

Freight In vs Delivery Expense
Freight In is the cost to have merchandise shipped to your store. Freight In is a cost of purchasing merchandise, and becomes part of Cost of Goods Sold in the Income Statement. Sometimes a company has to pay a separate charge for Freight In. At other times the cost may be included in the cost of merchandise from the supplier. In any case, the cost of Freight In is added to the cost of the merchandise.

example:
XYZ, Co. buys 100 units of Product R for $7500. The trucking company charges $500 for the shipment. The total cost of the merchandise is $8000. Each unit costs $8000 / 100 = $80. They should set their selling price based on a cost of $80.

Delivery Expense is the cost to ship or deliver merchandise to your customer after a sale. Delivery Expense is a Selling Expense, and is included under that caption in the Income Statement.

Read more...